AP Economics
©2014 Daniel Kim
www.onestudenttoanother.wordpress.com
#ch2
#conceptualquestions
1. Contrast how a market system and a command economy try to cope with
economic scarcity.
The market system and the command economy both have a task, the goal of
the study of economics itself. They need to distribute scarce resources. The
market system uses the natural balance of supply and demand, while
command economies use a logical algorithm derived by a third party, whether
it is a government, or a president.
2. How does self-interest help achieve society’s economic goals? Why is there such
a wide variety of desired goods and services in a market system? In what way are
entrepreneurs and businesses at the helm of the economy but commanded by
consumers?
In most modern economies, self interest creates supply of goods and services
that are considered “not essential” to life. Since we live in a supply/demand
3. Why is private property, and the protection of property rights, so critical to the
success of the market system? How do property rights encourage cooperation?
The market system encourages freedom and the ability for the consumer to
regulate demand. Since the whole system depends on the choices that the
consumer makes, property rights are critical to the system. Because a market
depends on people working for their own self-interest, if what you gain by
producing in the marketplace can be taken from you, then you have little
incentive to work. You can make the same argument concerning taxation that
simply takes what you have and hands it to others. The only difference is that
in the latter case the amount of your property loss is known.
4. What are the advantages of using capital in the production process? What is
meant by the term “division of labor”? What are the advantages of specialization in
the use of human and material resources? Explain why exchange is the necessary
consequence of specialization.
Using Capital in the production process often speeds up the process of
getting goods. Division of Labor is best explained by an example.
“One person washes dishes, while the other dries dishes, instead of one
person doing all of the work..” If England and Portugal can both grow wheat
and make wine. But England may grow wheat relatively cheaply and Portugal
make wine relatively cheaply. Each can specialize in what each does best and
have more wine and more wheat, but only if they can trade wine for wheat
5. What problem does barter entail? Indicate the economic significance of money as
a medium of exchange. What is meant by the statement “We want money only to
part with it”?
Barter requires the “double coincidence of wants.” If someone wants
something, he/she will have to find someone who wishes to part with that
good and at the same time wishes to exchange the good for something that
the first party wishes to part with. With money as a medium of exchange, one
knows the purchase price of the item to be purchased and its relative price to
other items. Money is a very convenient common denominator, a common
measure of value that is also used as a medium of exchange. Money also
encourages specialization. Without money, workers and other resources
could not be paid except in the output produced. All those who participated in
the production of the good would have to collectively exchange it for all the
goods and service desired by the resource owners. Money itself has value
only in relation to the resources, goods, and services that can be obtained
with it. When people say that they want money, they really mean that they
want the things that money can buy. In this sense, money imparts value only
when someone parts with it.
6. Evaluate and explain the following statements:
A. The market system is a profit-and-loss system.
In a market system, producer decisions are motivated by the attempt to earn
profits. Those products that enable a firm to earn at least a normal profit will
be produced. If the product cannot be produced for a profit—in other words, if
losses are involved in production—the capitalist firm will respond by seeking
lower cost production methods and may halt the production of goods
completely. Because profits and/or losses are the motivation behind the
fundamental decisions made in a market system, it could be called a “profit
and loss system.”
B. Competition is the disciplinarian of the market economy.
Competition provides discipline in two ways. First, it forces firms to seek the
least-cost production methods or face being driven out of business by their
rivals. Second, it prevents successful producers from charging whatever the
market will bear. Competition keeps prices at a level where total revenue will
just cover the total cost of production including a normal profit, but no more in
the long run. If sellers try to charge a price that will earn them economic
profits, new firms will enter the industry, increasing supply, and lowering
prices until the economic profits are eliminated. Competition is indispensable
in this role, because otherwise some other method would have to be found to
direct firms to use the least-cost production technique and to charge a price
that provides only a normal return. Where competition does not exist, such as
in natural monopolies like public utility companies, regulators or publicly
owned companies must assume the role of disciplinarian. Experience has
shown that this is a difficult process and does not achieve the same results as
easily as a competitive market situation.
7. What is meant by the term “creative destruction”? How does the emergence of
MP3/iPod technology relate to this idea?
What did iPods and MP3 players replace? CDs. What did CDs replace?
Cassette tapes and records. "Creative destruction" is the term that Joseph
Schumpeter coined to describe how a capitalist economy operates. New
(created) products replace old (destroyed) products. People voluntarily
choose the new over the old because the benefits they offer outweigh the cost
of learning something new. It's also very similar to the way nature operates.
The old are always being replaced by the new.
8. In a sentence, describe the meaning of the phrase “invisible hand”.
Invisible hand refers to the fact that the market will stabilize eventually if all
consumers have free will and supply and demand controls the economy.
9. In market economies, firms rarely worry about the availability of inputs to produce
their products, whereas in command economies, input availability is a constant
concern. Why the difference?
In a command economy, all firms get equal amount of resources, and does not
rely on the supply/demand of the people. Because there is a central source
that divides all resource in a command economy, there is no competition
amongst people who produce goods, which provides no incentive to produce
additional goods like the supply and demand command economy.
10. Distinguish between the resource market and the product market in the circular
flow model. In what way are businesses and households both sellers and buyers in
this model? What are the flows in the circular flow model?
The resource markets are where the owners of the resources (the
households) sell their resources to the buyers of the resources (businesses).
In the product markets, businesses sell the goods and services they have
produced to the buyers of the goods and services, the households.
Households (individuals) either own all economic resources directly or own
them indirectly through their ownership of business corporations. These
households are willing to sell their resources to businesses because
attractive prices draw them into specific resource markets. Businesses buy
resources because they are necessary for producing goods and services. The
interaction of the buyers and sellers establishes the price of each resource. In
the product market, businesses are the sellers and householders are the
buyers; their role in the market has been reversed. Each group of economic
units both buys and sells. One flow is the flow of real goods and services
(including resource services) and the other flow is the flow of money (money
income, consumption expenditures, revenue, production costs).
11. What explains why millions of economic resources tend to get arranged logically
and productively rather than haphazardly and unproductively?
Well, everything falls logically under the supply and demand system. When a
customer wants something for a certain amount of money, some supplier will
rise up and meet that demand.
#reallifeapplications
1. Go to the Internet auction site eBay at http://www.ebay.com and select the category
Jewelry and Watches, followed by Loose Diamonds and Gemstones, and then
Diamonds, Natural. How many natural diamonds are for sale at the moment? Note
the wide array of sizes and prices of the diamonds. In what sense is there
competition among the sellers in this market? How does that competition influence
prices? In what sense is there competition among buyers? How does that
competition influence prices?
There is competition among diamond sellers on ebay based on price and
quality. For example, there is a seller that is offering a 0.37 carat yellow
diamond for 200 dollars, while there is another seller that is offering 0.40 carat
golden diamond for 435 dollars. The basis for the difference of price for the
similar quality diamonds creates competition between the buyers to make the
market more competitive. Among buyers, there is competition in the sense
that they want to get the highest quality diamond for the cheapest price,
hence the auction. When a seller is offering diamonds at prices as low as 100
dollars, more than one buyer wants it at that price, which means that prices
will increase.
2. Bartering occurs when goods or services are exchanged without the exchange of
money. For some, barter’s popularity is that it enables them to avoid paying taxes to
the government. How might such avoidance occur? Does the Internal Revenue
Service (IRS),http://www.irs.ustreas.gov treat barter as taxable or nontaxable income?
(Type “bartering income” in the site’s search tool.) How is the value of a barter
transaction determined? What are some IRS barter examples? What does the IRS
require of the members of so-called barter exchanges?
It is apparent that the IRS considers barter exchanges as taxable
income after a certain point according to their website (100 transactions a
year) but this is probably far from reality. You picked right up on the issue
of enforcement- how to value such exchanges. This is an issue because
private production, like if someone grew their own food, is not taxed when
in essence it is no different than working for a wage and then buying food.
More of an issue is that such barters often do not contain any kind of
record for the IRS to base enforcement on. I do sheet metal and hvac work
during summers and I have a good friend who is a mechanic. Maybe I will
install a new ac unit for him or run central air into an addition to his house
if he would fix my car but we certainly wouldn't report that exchange where
we would both say make 1000 dollars if on the market but since we
bartered it was about an even trade.
For some major goods and services this may be quite beneficial
between individuals especially if the parties produce most of their own
consumption like farmers. For more specialized professions though barter
breaks down because of high search costs. This is the reason that first
commodity money and then fiat money came into existence. Like in my
example i do sheetmetal and hvac and am studying to be a lawyer. Imagine
if to get food I had to find a farmer who needed a new ac unit or legal
services - the search costs would pretty much preclude me from such
specialization and at best I'd have to grow my own food and then be a
lawyer on the side. This is not good for efficiency because I have a
comparative advantage at being a lawyer over a farmer.
The only reason the IRS probably even bothers is to prevent
widespread tax avoidance. There is nothing stopping small towns that
make most of their own consumption for bartering a large portion of their
economy and then just exporting their surplus for things from outside the
town. In reality this is what is happening anyway with just lower search
costs (because with money you only have to find some one who wants
what you have, sell it, then find what you want then buy it instead of
finding someone who both has what you want and wants what you have in
the barter economy). In such a barter town money income would be very
low and IRS revenues would be very low despite production being near the
same it was in a money economy.